Wednesday, 17 October 2012

Tale of two recessions

Imagine (again) the outbreak of a common
disease but as a new strain and on a scale not yet seen before. What makes diagnosis even more difficult is
that not only to the symptoms change over time but the disease itself mutates. What started as a banking
crisis in 2008 has morphed into a crisis of confidence in capitalism. The world is awash with cash as central banks
pump money into the economy but firms and banks prefer to hoard their funds
than put it to use. Yet the global
financial crisis is not the whole story and is different to the problems that
are plaguing the global economy recently.
And that is why Your Neighbourhood Economist is going to tell the tale
of two recessions.

The story starts what seems like a long
time ago with the boom period before the banking crisis. Rising house prices and stock markets seemed
to be ushering in a new era of prosperity and more and more investors followed
the mirage of easy money. Deregulation
in the finance sector allowed for more creative ways to make money which made
banks so complicated that the banks themselves did not understand their inner
workings and which exacerbated the problem by increasing the amount of debt
held by firms and households.

But with the gains in asset prices based on an
increasing amount of debt, all it would take was the slightest bit of trouble
and the house of cards would come tumbling down. The trigger seems to have been excessive
mortgage lending in the United States where banks competed to push mortgages to
individuals with low credit ratings. The
new creative streak among banks means that this dubious debt could be passed on
to others by being turned into bonds which was supposed to spread the risk but
also diluted lending standards. Cracks
started to appear in banks across the globe and the arteries of global finance
began to clog up as banks did not lend even to each other due to the possibility of
problems luring in their complex structures.
The crucial role of lending by banks as the life blood of any economy
mean that it was like the global economy suffering a heart attack.

Governments everywhere were jolted into
action – billions were thrown at banks to stop them going bust and the US
government even had to save the country’s largest car maker. Countries even banded together for a global
fiscal stimulus in 2009. But governments
in Western countries had also been found wanting – politicians too had believed
the good times would last and had been reckless in their spending.

Economies rebounded in 2010 with help from
the limited stimulus packages that governments could manage but a bigger boost
came from continued growth in emerging markets which had not been caught up in
the same hubris as the West. But the
hangover from the previous debt-fuelled party still lingered as excessive
amounts of borrowing prompted firms to go bust and consumers to be weighed down
by mortgages worth more than their homes.
And the situation was made worse as bankers were targeted as the bad
guys of the crisis and the banking sector were hit with a battery of new
regulation which further restricted its ability to lend (refer to Another reason not to bank on Europe).

The weak recovery has been like an infection
which has sapped the willingness of firms to invest and to take on new
workers. Investment in particular is
typically the driving force of economic growth (for more detail on investment in the economy - Investment in China) but companies need to be confident of a
return on their investment. Problems
such as the sovereign debt crisis in Europe and the lack of a plan to deal with
growing government debt in the US have added to the debilitating degree of
uncertainty which is plaguing firms. The
lack of confidence in future growth is creating the circumstance for a downward
spiral where hoarding of cash by firms further drags on growth and brings down
confidence.

Governments are also limited in their
ability to act by the overload of debt.
Austerity seemed to offer up a cure through easing concerns in the bond
market but cuts to government spending seem to be more like a treatment of leeches
– a bit out-of-date and likely to do more harm than good. But the belief in austerity still holds sway
despite the IMF suggesting it may not be the best course of action (see Time for Plan B?). Without a clear consensus on the need for an
alternative, decisive action such as another global stimulus package looks
unlikely. No happy ending is likely any time soon.